Friday, October 7, 2016

Thirlwall’s Law: An Overview and Bibliography

“Thirlwall’s law (named after Anthony Thirlwall) states that if long run balance of payments equilibrium on current account is a requirement, and the real exchange rate stays relatively constant, then the long run growth of a country can be approximated by the ratio of the growth of exports to the income elasticity of demand for imports (Thirlwall, 1979).

If the real exchange rate varies considerably, but the price elasticities of demand for imports and exports are low, the long run growth of the economy will then be determined by the growth of world income times the ratio of the income elasticity of demand for exports and imports which are determined by the structural characteristics of countries. One important example of this is that if developing countries produce mainly primary products and low value manufactured goods with a low income elasticity of demand, while developed countries specialise in high income elasticity manufactured goods the developing countries will grow at a relatively slower rate (Davidson, 1991).”
https://en.wikipedia.org/wiki/Thirlwall%27s_Law

Thirlwall’s paper “The Balance of Payments Constraint as an Explanation of International Growth Rate Differences” (1979) was the foundational work on this law.

Thirlwall’s law is a growth model for capitalist economies that focuses on the demand-side and the balance of payments constraint.

For example, if a nation’s growth path takes it down the route where it runs constant balance-of-payments deficits financed by short-term capital inflows, then this in the long run may well lead to unsustainable exchange rate depreciation and, in extreme cases, exchange rate collapse and hyperinflation (McCombie 2012: 19).

It is better, therefore, that in the long run a nation has a tendency to balance current account and long-term capital flows (McCombie 2012: 19).

Specifically, we can note these important factors:

(1) a nation’s export growth depends on world demand and its exchange rate competitiveness. Thirlwall’s law throws aside the unrealistic assumption of global full employment demand or the natural tendency to full employment (Davidson 2011: 246);

(2) internal demand for imports depends on growth of domestic real income and relative prices;

(3) for many countries, a crucial factor determining long-run growth is the growth of exports to ensure a sustainable balance of payments path;

(4) the neoclassical real exchange rate adjustment mechanism is a flawed model of reality. In reality, downwards nominal wage rigidity, cost-based mark-up prices adjusting to changes in the prices of imported factor inputs, and the relatively inelastic demand for many types of export commodities thwart this mechanism.

(5) the upshot is that economic growth needs to take account of the balance-of-payments constraint, and that import substitution and export promotion policies need to take account of this too, and export products should be focussed on goods for which world demand is strong, and growing. An additional point from Post Keynesian trade theory is that manufacturing is crucial to create sectors in which increasing returns to scale and clustering effects (from new industries creating factor-inputs for the manufacturing sector) occur, which will be the key to successful development.

As Davidson (2011: 248) notes, letting free markets determine balance of payments dynamics is likely to doom many Third world nations to poverty.

4 comments:

"For example, if a nation’s growth path takes it down the route where it runs constant balance-of-payments deficits financed by short-term capital inflows, then this in the long run may well lead to unsustainable exchange rate depreciation and, in extreme cases, exchange rate collapse and hyperinflation"

It's certainly an interesting theory, and I think the Export-Oriented Industrialization vindicates it for the most part. But remember that EOI also typically necessitates running trade surpluses in manufactured goods against the rest of the world, and does lead to unemployment in Developed nations.

It's also interesting to look at how this applies to Import-Substitution Industrialization (ISI). I think many post-Keynesians have a better opinion of this period than neoclassicals, albeit with a significant amount of criticisms of it too. Basically the regimes would put very high tariffs in place, overvalue their currency to import capital at a discounted rate, and try to develop their own manufacturing base in isolationa against the rest of the world. Some other punative measures were taken, like export taxes/tariffs against primary goods such as cattle/beef in Argentina (this was more of a political measure to punish the previous Elite), and the subsidization of primary goods and foodstuffs is also well known.

Well, growth during this era was pretty rapid. See: "The Mexican Miracle", though GDP per capita growth not as great (but still significant) given these places still had high fertility rates.

Ultimately, the ISI regime came tumbling down thanks to the new floating exchange regime of the dollar, the massive credit inflows from US Banks like Citibank and JP Morgan, and the rise and fall of commodities. When Volcker hiked rates, he also doubled the value of the dollar, doubling the effective interest payments, and in many cases the interest rates themselves (quadrupling them in those cases). So clearly, capital inflows that act as debt with high interest rates are a terrible idea. If they are FDI, or even if they're purchasing treasury bonds, real estate or stocks, it's distortionary but more benign.

Anyways, I think the primary problem with the "trade deficits" balance of payments issue, is that all too often they're not importing Capital goods to help industrialization, but instead they're importing food and luxury goods. This may be a wider problem with developing nations with fragile democracies, autocracies, kleptocracies and democracies that are otherwise ruled by Oligarchs (i.e., pre-Chavez Venezuela).

Even in floating currency regime if the country is under free trade policy,and the country is using deficit spending in order to insure full employment.

Nonsense. There is absolutely no such "foreign" mechanism for a non-basket case country in a floating rate regime, which is not facing an embargo / blockade from the rest of the world. This is the usual case. The "barter" value of its exports put a floor under the fx value of its currency. The worst case that can happen is continuous exchange rate depreciation. Could be x% depreciation forever for a not very big x. Big Deal. This depreciation is self-correcting with respect to the pass-through to domestic inflation, so there is no way whatsoever for foreign trade to cause hyperinflation. The rough amount of NFA is controlled by the domestic government. Abba Lerner discussed this thoroughly long ago.